The transmission mechanism of monetary policy

Box 9 The transmission mechanism of monetary policy

The starting point of the transmission process of monetary policy is the changes in money market rates which the central bank can trigger through its control over money market conditions. Changes in money market rates in turn affect other interest rates, albeit to varying degrees. For example, changes in money market rates have an impact on the interest rates set by banks on short-term loans and deposits. In addition, expectations of future official interest rate changes affect longer-term market interest rates, since these reflect expectations of the future evolution of short-term interest rates. However, the impact of money market rate changes on interest rates at very long maturities (e.g. 10-year government bond yields, long-term bank lending rates) is less direct. Those rates depend to a large extent on market expectations for long-term growth and inflation trends in the economy. In other words, changes in the central bank’s official rates do not normally affect these longer-term rates unless they were to lead to a change in market expectations concerning long-term economic trends.

Because of the impact it has on financing conditions in the economy – but also because of its impact on expectations – monetary policy can affect other financial variables such as asset prices (e.g. stock market prices) and exchange rates.

Changes in interest rates and financial asset prices in turn affect the saving, spending and investment decisions of households and firms. For example, all other things being equal, higher interest rates tend to make it less attractive for households or companies to take out loans in order to finance their consumption or investment. Higher interest rates also make it more attractive for households to save their current income rather than spend it, since the return on their savings is increased. Furthermore, changes in official interest rates may also affect the supply of credit. For example, following an increase in interest rates, the risk that some borrowers cannot safely pay back their loans may increase to a level such that banks will not grant a loan to these borrowers. As a consequence, such borrowers, households or firms, would be forced to postpone their consumption or investment plans.

Finally, movements in asset prices may affect consumption and investment via income and wealth effects. For example, as equity prices rise, share-owning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may well reduce consumption. An additional way in which asset prices can impact on aggregate demand is via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks. Lending decisions are often influenced to a large extent by the amount of collateral. If the value of collateral falls then loans will become more expensive and may even be difficult to obtain at all, with the result that spending will fall.

As a consequence of changes in consumption and investment, the level of domestic demand for goods and services relative to domestic supply will change. When demand exceeds supply – all other things being equal – upward pressures on prices emerge. Moreover, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets, and these in turn can affect wage and price- setting in the respective market.

Box 9 T h e t r a n s m i s s i o n m e c h a n i s m o f m o n e t a r y p o l i c y ( c o n t ’d )

Changes in the exchange rate will normally affect inflation in three ways: First, exchange rate movements may directly affect the domestic price of imported goods. If the exchange rate appreciates, the price of imported goods tends to fall, thus helping to reduce inflation directly, insofar as these products are directly used in consumption. Second, if these imports are used as inputs into the production process, lower prices for inputs might, over time, feed through into lower prices for final goods. Third, exchange rate developments may also have an effect via their impact on the competitiveness of domestically produced goods on international markets. If an appreciation in the exchange rate makes domestically produced goods less competitive on the world market, this tends to constrain external demand and thus reduce overall demand pressure in the economy. All other things being equal, an appreciation of the exchange rate would tend to reduce inflationary pressures. The importance of these exchange rate effects will depend on how open the economy is to international trade. The exchange rate channel of monetary policy transmission is less important for a large, relatively closed currency area like the euro area than for a small open economy. Clearly, financial asset prices depend on many other factors in addition to monetary policy, and changes in the exchange rate are also often dominated by these factors.

Other channels through which monetary policy can influence price developments mainly work by influencing the private sector’s longer-term expectations. If a central bank enjoys a high degree of credibility in pursuing its objective, monetary policy can exert a powerful direct influence on price developments by guiding economic agents’ expectations of future inflation and thereby influencing their wage and price-setting behaviour. The credibility of a central bank to maintain price stability in a lasting manner is crucial in this respect. Only if economic agents believe in the central bank’s ability and commitment to maintain price stability will inflation expectations remain firmly anchored to price stability. This in turn will influence wage and price-setting in the economy given that, in an environment of price stability, wage and price-setters will not have to adjust their prices upwards for fear of higher inflation in the future. In this respect, credibility facilitates the task of monetary policy.

Source: ECB (2004), The monetary policy of the ECB, pp. 44-47.

The transmission mechanism of monetary policy is thus a complex web of economic interactions, and central banks are confronted with long, variable and uncertain lags in the conduct of monetary policy. The ECB may even face more uncertainty than many other central banks since it is responsible for a multinational currency area that was only established in 1999. Moreover, institutional and behavioural changes following the introduction of the single currency may have changed the relationships between different economic variables. As more information and research results have become available over time, a more detailed understanding of monetary policy transmission in the euro area has developed. Nevertheless, further progress is needed.

3 . 1 . 2 T h e E C B ’s m o n e t a r y p o l i c y s t r a t e g y

The first element of the ECB’s monetary policy strategy is a quantitative definition of price stability. In addition, the strategy provides for a framework which ensures that the Governing Council of the ECB assesses all the relevant information and analysis needed to take monetary policy decisions in a forward-looking manner.

Ta k i n g a q u a n t i t a t i ve a p p r o a c h t o p r i c e s t a b i l i t y

Although the EC Treaty clearly establishes maintaining price stability as the primary objective of the ECB, it does not define what “price stability” actually means.

With this in mind, in October 1998 the Governing Council of the ECB announced

a quantitative definition of price stability. There were three main reasons for choosing a quantitative approach:

1. The definition helps to make monetary policy more transparent.

2. A quantitative definition provides a yardstick against which the public can hold the ECB accountable. As deviations of price developments from price stability can be easily identified, the ECB must account for sustained deviations from this definition and explain how price stability will be re- established within an acceptable period of time.

3. The definition is intended to guide expectations of future price developments and thus build up credibility and increase the effectiveness of the ECB’s monetary policy. The ECB’s overriding commitment to maintain price stability should give both financial markets and the public good reason to expect that medium-term inflation will lie within the range deemed compatible with price stability. Stabilising longer-term inflation expectations in this way should help to prevent firms, trade unions and individual agents involved in the wage and price- setting process from incorporating higher rates of inflation into their decisions which, in turn, would make it more difficult to maintain price stability.

T h e E C B ’s d e f i n i t i o n o f p r i c e s t a b i l i t y

In October 1998 the Governing Council of the ECB defined price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%” and added that price stability ”was to be maintained over the medium term”. The Governing Council confirmed this definition in May 2003 following a thorough evaluation of the ECB’s monetary policy strategy. On that occasion, the Governing Council clarified that “in the pursuit of price stability, it aims to maintain inflation rates below but close to 2% over the medium term”.

The reference to “the HICP for the euro area” indicates two things: first that the goal of the ECB’s monetary policy is price stability in the euro area as a whole, and second that it reflects the public’s usual focus on consumer prices. The HICP is the index that most closely approximates the changes over time in the price of a representative basket of consumer goods and services purchased by euro area households.

The phrase “below 2%” sets a clear upper boundary for the rate of measured HICP inflation that is consistent with price stability over the medium term. At the same time, aiming for low positive inflation rates “close to 2%” provides “an

adequate margin to avoid the risks of deflation” 1 (see Box 10). In addition, it takes into account the possible presence of a measurement bias in the HICP and the implications of inflation differentials of a structural nature within the euro area.

Finally, the term “over the medium term” reflects the consensus that monetary policy cannot fine-tune developments in prices or inflation over short horizons of a few weeks or months. Changes in monetary policy only affect prices with a time lag, and the magnitude of the eventual impact is uncertain. This implies that monetary policy cannot offset all unanticipated shocks to the price level in a short period of time. Some short-term volatility in inflation is therefore inevitable.

T h e m a i n p r i n c i p l e s o f t h e E C B ’s m o n e t a r y p o l i c y s t r a t e g y

The ECB influences conditions in the money market, and thus the level of short- term interest rates, in such a way that price stability is best maintained over the medium term through the effects on the price level via the monetary policy transmission process. It does this in line with its monetary policy strategy to ensure that a consistent and systematic approach is taken to monetary policy decisions over time. Such consistency helps to stabilise inflation expectations and bolster the ECB’s credibility.

Given the lags in the transmission process, monetary policy changes made today will only affect the price level after a number of months or even years. This means that central banks need to ascertain what policy stance is needed today to maintain price stability in the future. In this sense, monetary policy must also be forward-looking.

Furthermore, as the transmission lags make it impossible in the short run for monetary policy to offset unanticipated shocks to the price level (for example, those caused by changes in international commodity prices), some short-term volatility in inflation rates is unavoidable. In addition, owing to the complexity of the transmission process, there is always a large element of uncertainty surrounding the effects of monetary policy. For these reasons, a medium-term orientation of monetary policy is important: it is consistent with the ECB’s statement that “price stability is to be maintained over the medium term” and avoids excessive activism and the introduction of unnecessary (and possibly self- sustaining) volatility into the real economy.

Finally, the ECB is faced with considerable uncertainty about the reliability of economic indicators, the structure of the euro area economy and the transmission mechanism of the single monetary policy, in particular during the first few years of EMU. However, all central banks face a large degree of uncertainty – this is certainly not unique to the ECB – and so a successful monetary policy must therefore be broadly based, taking into account all the relevant information and not relying on a single model of the economy.

1 See ECB (2004), The monetary policy of the ECB, p. 51.

Box 10 W h y m a i n t a i n a l ow p o s i t i ve r a t e o f i n f l a t i o n ?

Avoiding deflation is important because it entails similar costs to the economy as inflation. Furthermore, once deflation occurs it may become entrenched as nominal interest rates cannot fall below zero.

• Maintaining a low positive rate of inflation reduces the probability that nominal interest rates will approach their lower boundary at zero. If nominal interest rates hit zero, there is likely to be increased uncertainty about the effectiveness of monetary policy. And if this event were to coincide with a strong decline in demand, such a situation could complicate the central bank’s ability to restore price stability by using its interest rate instrument. Examples of this are rare and even if it were to occur, a number of effective monetary policy actions are still possible at zero nominal interest rates. Various plausible solutions for escaping from a liquidity trap have been proposed. Despite this, prevention is better than cure and a safety margin for inflation rates above zero helps to avoid the need to test the effectiveness of these alternative policies in practice.

In order to calibrate the safety margin for inflation rates, the ECB took account of studies which have tried to assess the likelihood of nominal interest rates hitting the zero lower boundary for various levels of inflation objective. Results in this area differ to some extent, as they depend on a number of specific assumptions. But the available studies indicate that the likelihood decreases dramatically when the central bank aims at an inflation rate above 1%.

• The second reason for aiming at low positive inflation is that inflation statistics may be subject to a positive measurement error. This error would imply that zero inflation means de facto a declining price level. In the specific case of the HICP, the precise estimation of such a measurement bias continues to be surrounded by uncertainty. But taking into account the continuous improvements implemented by Eurostat in the index, the bias is likely to be small and to decline further in the future.

• The third reason for aiming at low positive inflation is linked to the possible presence of sustained inflation differentials within the euro area. In principle, inflation differentials across the regions are a normal feature of any monetary union. They are an integral part of the adjustment mechanism resulting from divergent economic developments across regions forming the area in which monetary union has been established. However, the single monetary policy can only influence the price level of the area as a whole; it cannot address inflation differentials, in the same way that monetary policy in a single country cannot reduce inflation differentials across regions or cities.

Inflation differentials due to transitory factors are of little economic concern. Of greater concern are the structural inflation differentials resulting from incomplete real convergence between regions, for example, initial differences in income levels and an ongoing catch-up process in standards of living. Their emergence could potentially create economic problems in countries or regions with below-average inflation, particularly if downward nominal rigidities impede the necessary adjustment of relative prices and thus hamper the efficient allocation of resources.

Box 10 W h y m a i n t a i n a l ow p o s i t i ve r a t e o f i n f l a t i o n ? ( c o n t ’d )

It has been argued that the ECB’s monetary policy should target a medium-term inflation rate for the euro area that is high enough to prevent regions with structurally lower inflation rates from having to meet the costs of possible downward nominal rigidities or entering periods of protracted deflation. Available studies agree that a rate of inflation below but close to 2% for the euro area provides a sufficient margin in this respect.

T h e t wo - p i l l a r a p p r o a c h o f t h e E C B ’s m o n e t a r y p o l i c y s t r a t e g y

The Governing Council of the ECB agreed on the main elements of its monetary policy strategy in October 1998. The strategy was confirmed and further clarified in May 2003 after an extensive review of all relevant aspects.

In addition to the definition of price stability, the ECB uses two analytical perspectives (referred to as the two “pillars”) as the basis for its approach to organising, evaluating and cross-checking the information relevant for assessing the risks to price stability:

• The first perspective is aimed at assessing the short to medium-term determinants of price developments, with a focus on real activity and financial conditions in the economy (economic analysis).

• The second perspective (monetary analysis) mainly serves as a means to cross-check, from a medium to long-term perspective, the indications from the economic analysis.

The two-pillar approach (see Box 11) ensures that appropriate attention is paid to different perspectives to be able to make an overall judgement of the risks to price stability. The diversified approach to the interpretation of economic conditions reduces the risk of policy error caused by over-reliance on a single indicator, forecast or model.

Chart 2 T h e s t a b i l i t y - o r i e n t e d m o n e t a r y p o l i c y s t r a t eg y o f t h e E C B

Source: ECB (2004), The monetary policy of the ECB, p. 66.

Box 11 T h e t wo p i l l a r s o f t h e E C B ’s m o n e t a r y p o l i c y s t r a t e g y

The two pillars of the ECB’s monetary policy strategy are economic analysis and monetary analysis.

Economic analysis

The economic analysis focuses on the assessment of current economic and financial developments and the implied short to medium-term risks to price stability. It analyses all factors which are helpful in assessing the dynamics of real activity and the likely development of prices in terms of the interplay between supply and demand in the goods, services and labour markets. The economic analysis also pays due attention to the need to identify the nature of shocks hitting the economy, their effects on cost and pricing behaviour and the short to medium-term prospects for their propagation. To take appropriate decisions, the Governing Council needs to have a comprehensive understanding of the prevailing economic situation and be aware of the specific nature and magnitude of economic disturbances which threaten price stability.

The ECB regularly reviews developments in overall output, demand and labour market conditions, a broad range of price and cost indicators, fiscal policy, and the balance of payments for the euro area. Developments in financial market indicators and asset prices are also closely monitored. Movements in asset prices may affect price developments via income and wealth effects. For example, as equity prices rise, share-owning households become wealthier and may choose to spend more on consumption. This adds to consumer demand and may fuel domestic inflationary pressures. Conversely, should equity prices fall, households may reduce consumption.

Asset prices and financial yields can also be used to derive information about expectations in the financial markets, including expected future price developments. For example, when buying and selling bonds, financial market participants implicitly express expectations about future developments in interest rates and prices. Using a variety of techniques, the ECB can analyse financial prices to extract the markets’ implicit expectations for future developments.